The dozy watchdogs, a “briefing” from the Economist of 13 December 2014, highlights a few cases of frauds worldwide and goes on to conclude that frauds continue unabated. To suggest scrapping of legal requirements for audits is similar to withdrawing the police force from law and order duty because robberies and murders continue or banning annual health checks because they don’t detect cancer or some serious tumor! To say this in a responsible manner ‘The economist’ should find out how many frauds and fraudulent reportings have been deterred or prevented by auditors, worldwide. Though I’m not qualified to give a number I’m sure it’s more than the few ‘bad cases’ reported in the news. Even in the said companies, there may have been other significant losses that were avoided due to the audit, which an auditor cannot publicize in the news papers, due to client confidentiality rules.

How many wars do the auditors fight on a daily basis with managements and audit committees to prevent such cases as in Tesco, Hewlett Packard, Olympus, Sino Forest or at Satyam and more as reported in the said briefing. Management and Boards that are out to hoodwink investors can do it under the strictest laws. Just because Murder is illegal and punished in every country in the world, has it stopped or isn’t there more murders being reported daily in the news? The comparison should be with a situation which does not have any protection. Wouldn’t it be like the law of the jungle? If so why is modern society governed by laws and rules, etc…

I have to agree that I don’t have the answer to these situations nor do the most powerful persons in the world have an answer! Therefore, regulators, news reporters, auditors, investors and other stakeholders have to fight for better governance in corporates to prevent frauds and false reporting. The fight is ongoing and we cannot give up and throw out the baby with the bath. How irresponsible would it be to withdraw the Army, just because terrorists continue to kill innocent people? How irresponsible would it be not to fight a election just because undemocratic villains rig elections? How irresponsible would it be to ridicule health checks suggested by doctors and insurers? How irresponsible would it be for the Economist to suggest scrapping of mandatory audits and not prevent, deter and reduce frauds?

To prevent or at least reduce the impact of fraudulent reporting, audit committees need to ask intelligent questions. Auditors should alert audit committees of contentious issues and audit committees should be able to protect such good auditors, rather than use the excuse of “rotation” and seek out others who will not be “difficult”. Some questions that the audit committees can ask to improve governance are set out in my other previous posts. Some key ones to consider may be;

#1 Has the audit committee considered the processes in place to generate forecasts of cash flow and accounting valuation information, including the choice and consistent use of key assumptions?
#2 Is the revenue process supported by appropriate internal controls and reasonableness checks and have those internal controls been tested by internal and/or external audit?
#3 Do models and key assumptions adequately address low probability but high impact events, including the need for changes in the approach to valuations and key assumptions underlying forecasts since last year ?
#4 Where assets are not traded, perhaps because markets are no longer active, is the committee satisfied that appropriate additional procedures have been undertaken to estimate fair values through the selection of market-based variables and the use of appropriate assumptions?
#5 Have the auditors been asked for a written summary of their views on the assumptions that underlie cash flow forecasts and other estimation techniques used to value assets and liabilities and is the committee satisfied that any material concerns have been properly addressed by management?

2 Responses to How silly does “The dozy watchdogs” sound?

Suren, I think you have taken an uncharacteristically defensive stance in this post.

The Economist’s briefing suggests the profession’s self-regulation of auditors has “set the bar so low that it is all but impossible for them to fail at their jobs as they define them”. That is a serious accusation, which should not be casually dismissed.

The briefing thinks audits evolved to provide an efficient and enlightened way to keep managers and their financials, honest; it suggests they have failed because of limitations the profession itself has placed (and been allowed to place) on the auditor’s role and responsibilities. So it suggests external regulation is necessary.

It says improvement can come from a replacement of the conventional audit report with a more detailed one (and says the UK has already done this).

The briefing ends by noting that free-market purists may argue that the legal requirement for an audit should be scrapped, saying auditors will then have to devise (and compete for) audits that investors actually find useful, to stay in business.

While accepting that the integrity of financial statements is primarily a management responsibility, these thoughts do seem valid to a non-auditor.

Not defensive Richard, trying to present a pragmatic side. External regulations (only) will not stop frauds. PCAOB view in the briefing suggests so? Any change or expansion of scope is possible, but it will significantly increase time and costs of audits. Having the knowledge of such discussions I know it will still leave a ‘yawning gap’ as mentioned in the article.
The capital market is better off improving governance and keeping audits as a health check rather than making it an investigation. Forensic audits are performed when required at a very high cost. If regulators require they may commission such audits on specific companies only. Just because a few break the rules, everybody should not be put through a rigorous process. The difference between the age old thinking of watchdogs and bloodhounds can be maintained if everybody is sensible about the purpose. Criminals will break the law, under any regime, it’s better if investors don’t follow such companies for short term gains.
May be Gordon Gekko the fictional character from Wall Street understood the cause and effects of the above.